Many of you may be familiar with Christian author and radio host Dave Ramsey. For anyone who is not, Mr. Ramsey is famous for advocating being debt-free and paying cash for everything. Mr. Ramsey never forgets to tell his audience that he once filed for bankruptcy. Indeed, that seems to be the main credential for his advice on financial matters. And that is pretty much the entire extent of his financial expertise.
Dave gets one thing right: the Bible does caution people about going into debt.
The rich ruleth over the poor, and the borrower is servant to the lender. – Proverbs 22:7
My problem with Mr. Ramsey stems from his advice on investments, as well as the type of person that he interacts with on-air. You see, I have never heard a ‘normal’ person call in to Mr. Ramsey’s show. No, it’s always someone who is making over $100,000 per year and who has been spending like a drunken sailor. At least they were, until they heard Dave on the radio or bought one of his books and realized that they are idiots with money. And they then proceed to tell Dave how they paid off their $40,000 of credit card debt over a period of 18-24 months.
Hallelujah! You are cured (of being an idiot)!
Heck, I once heard a guy with over $2 million in assets tell good ol’ Dave how he paid down his $400,000 in debt…by selling some of his assets. Look, if you have $2 million in assets, your debt level of 20% isn’t a problem. If you make more than the average American ($50,000 per year) you shouldn’t be having serious financial problems unless you are an idiot. And you don’t have to call a multimillionaire (Dave has a net worth of more than $50 million) to find out that you should cut expenses and stop being a dumbass with your spending.
But what really ground my gears happened the last time I listened to Dave’s radio show. The caller was a 24-year old college graduate making $50,000 per year. This kid was in good financial shape, having paid off half of his student loan debt in 2 years. He was calling to ask Dave’s advice on his employer’s 401k program.
Dave advised him to max out his contributions, and then took a side trip to Fantasy Land. Dave used some funky new math to project that, if this kid put away $7,500 per year for the next 40 years, he would have $7.3 million in his account when he retired. The kid was ecstatic. I, on the other hand, turned off my radio in disgust.
Why? Well, here’s how Dave got to that $7.3 million on an investment of only $300,000 ($7,500 x 40). First, he assumed that this kid was going to be making $50,000 per year (at least) for the next 40 years. He didn’t take into account the fact that his employer might downsize or go out of business, or that they wouldn’t fire this kid in 10 years and bring in a new college graduate (or foreign worker) who will work for less money. It’s a cliche’ nowadays, but I know several people that this has happened to in the last few years.
Not to mention the fact that this kid might meet a girl, get married, and have kids. Or get disabled in a car accident, or find cancer growing inside of him. All of which would result in a higher level of expenses than he has right now, and all of which might result in a lower contribution to his retirement funds. Not to mention that prices will increase to the point where that fictional $7.3 million will barely pay his living expenses in 40 years.
And here’s the kicker: Dave compounded the $300,000 by a 12.5% return every year.
This is completely unrealistic in a financial world where interest rates on long-term CDs are barely above 1%, and U.S. Treasury securities pay an interest rate of between 3% and 5%. Dave pulls this 12.5% rate of return out of his … um … experiences investing in index funds. What Dave fails to tell his listeners/groupies/cult members is the name of the exact fund(s) that he is investing in to achieve this phenomenal return on investment and where they can sign up. And the reason why is probably that the fund is either (1) closed to new investors, or (2) the fund is not open to people who do not reach a certain net worth (of say, maybe, $50 million?) like good ol’ Dave.
You see, there are certain high-risk investment options that are only available to people who already have wealth. And these investments provide a higher rate of return than that crappy CD at the bank, or that U.S. Treasury security that your grandma gave you on your 12th birthday. If you don’t make the cut financially, well, tough noogies. You don’t get to invest and make that 12.5%.
I wouldn’t be surprised if that kid calls Dave back in a few years and tells him about how the government confiscated his 401k, he lost everything in his divorce, and how Dave was full of shit with his 12.5% projection. Of course, that call would never go live on the air. Because that might cost Dave some money. And that would be bad for his business.
Update: In a 2013 article, Money magazine agreed with me about Dave’s unrealistic rate of return:
In fact, this is unhinged from the reality of the investing world. “I don’t see how anybody can count on 12% annual returns,” says William N. Goetzmann, professor of finance at Yale. Part of the issue is a wonky-sounding math point, which you can see illustrated below (click the image for a larger view). Correctly calculated, the long-term return on stocks since 1926 is closer to 10% — before taking out mutual fund fees and front-end sales costs.
And if you follow Ramsey, you’re likely to pay sales charges: Outside a 401(k), he recommends A-share “load” funds sold via advisers. That’s because, he says, people need a pro to help them stick to their plan and not jump out when an investment underperforms.
The other problem with 12% is obvious: the experience of the past 13 wild years. While some periods, like the 1980s and ’90s, do deliver double-digit returns, investors know they can also see long stretches — perhaps in their peak saving or retirement years — earning a lot less.
Ramsey recently debated that subject on his radio show with Brian Stoffel, a columnist for The Motley Fool, who wrote about that 12% number in the wake of the Twitter fight. Stoffel said 12% was unrealistic; Ramsey said that it wasn’t, and that if his listeners had taken his advice and followed it for the past 20 years, “they would have had a pretty strong rate of return.” He challenged Stoffel “to analyze that and figure that out,” which Stoffel obviously couldn’t do on a live radio show.
But here are the numbers, using data from Morningstar. If someone invested equally in four mutual funds corresponding to Ramsey’s plan, using the kind of load-charging funds he recommends, over the past 20 years the annualized return would have been 7.6%.
The writer at Money also brings up something I overlooked: Dave Ramsey tells people that they should be able to live on an income equal to 8% of their savings in retirement. Alas, Dave is assuming that the stock market will always rise. A stock market crash would change Dave’s assumptions dramatically:
If you simply take out 8% of your portfolio balance every year, your income could drop 40% after a year like 2008. Alternatively, if you took out 8% your first year and then increased your income to keep up with inflation in the following years, you’d risk running out of money fast if you hit bad markets early in your retirement.
With an all-stock portfolio, using actual returns from 1926 to 2009, an 8% initial rate would have a 24% chance of draining your account in 15 years, as you can see in the following graphic (click on the image to enlarge.) That’s why planners often recommend half that rate.
I swear, he’s so wrong about investing that it’s almost like Dave has a PhD.